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The Picture of Gold: It Takes a Bubble to Heal a Bubble

|Includes: ABX, AU, AUY, BAA, FCX, GDX, GLD, GOLD, KGC, NEM, NGD, Nevsun Resources Ltd. (NSU), SLV
If a picture is worth a thousand words, then today the picture of the gold market in words is worth slightly less than three times the current value of gold. These 3,000 words combine to tell a story of a market that has been shaped by four economic and psychological phenomena: the economic policy, public confidence, speculation, and the interplay between interest rates and debt levels on the nation’s balance sheets.

During Alan Greenspan’s tenure as the Fed chairman, gold prices had been viewed as a leading indicator of the adjustments in the Federal Funds rate. This was often interpreted as the application of an implicit gold standard by Greenspan, its devout proponent. The practice seems to have been abandoned in the age of new bubbles because the rising money supply, widely believed to be a proxy for inflation, had little to do with the supply of inflation in the economy.

As the money supply increased progressively over the past several decades, inflation and interest rates trended downward. Instead of charging inflation, the noted flood of (partly misallocated) liquidity was fuelling speculative investments, such as those in housing, which served as a life-line for the economic activity that was overburdened by high levels of debt. Little was known then by the policymakers about the high price the U.S. would have to pay because of the efforts to rescue the economy and “to muddle through” the debt problems by flooding the world with cheap money. These efforts were simply inflating the bubbles in the debt-loaded corporate and household balance sheets. When the bubbles burst, it took yet another bubble to remedy the problem.

The U.S. government’s great rescue mission to save the economy and the collapsing financial system—through nationalization of Fannie Mae, Freddie Mac, AIG, et al.—required an even greater monetary and fiscal injection, which has sent the U.S. public debt through the roof. The mission was a success because of the government’s ability to “create money” out of thin air—an effort that would not have been possible under a gold standard.

However, under a gold standard, the problem would not have developed in the first place. What actually happened was the subsidization by the U.S. taxpayers of the years of excesses in the financial system and the economy’s balance sheets. The price tag for this protracted job can be easily measured in gold—the chart below summarizes the bill.

Still, the decade-long run-up in gold prices is not only symptomatic of the rising money supply following the dot-com fiasco, the 9-11 terrorist attacks, Iraq and Afghanistan wars, and the ’01 recession. It is also a reflection of the general public’s faltering confidence in the economy and the government. This is not a surprise given the bruising losses to net worth of most Americans from rising unemployment and deflating bubbles, which were partly government-sponsored.

The mounting economic uncertainty, especially amid new anxieties about a double dip and a protracted period of deflationary pressures, could all but help restore the shaken confidence of consumers and investors. The focus, however, is shifting to Europe, which is now responsible for the renewed instability in the capital markets. In fact, the latest leg in gold’s upward thrust, coincident with that in the dollar, was driven entirely by the loss of confidence in the Euro and in the capacity of the fragmented EU government to handle its crises.

The European debt crisis—which is likely not over yet—has revealed who really has the upper hand when it comes to handling the economic and financial crises. It is clearly a victory for the U.S. federal government which has a more cohesive and, thus, a more effective monetary and financial regulatory architecture compared with the nascent EU structures. The European monetary union does not have any effective fiscal oversight over the member states’ finances. Hence, the U.S. dollar rests on a firmer foundation than does the Euro and is nowhere near losing its status of the world’s fiat currency.

The reaction of gold to the plunge in the Euro shows that confidence in the government’s capacity to react to economic shocks is not tied only to the policies of the U.S. government. In the intertwined global financial and capital markets, it is the relative relationships among the major players that affect the movements in the market. When the Euro is shaken, the dollar will rise; and amid fears of a contagion, gold may rise as well.

Gold and Inflation: No Hedging Necessary
The recent concerns about a double-dip recession have revived fears of deflation, which has been viewed by some as an excuse to revive the economy with new money creation. Increasing liquidity may be necessary in order to take the economy away from the brink of another downturn. Whether it is successful or not is a question, given that a number of forces interact to affect the general level of prices of goods and services, one of which—and to a lesser extent in the recent years—is money supply.

U.S. interest rates have been on a secular downtrend (see chart below), mostly because debt burdens have risen to levels that prohibit major rate increases. The last round of interest rate hikes is responsible for bursting household and corporate sectors' debt bubbles. While private sector debt levels relative to GDP or income have declined substantially in the recent years, they still remain elevated. Because of this debt, any large increase in interest rates in the next few years could be detrimental to the financial stability and the economy.

Comment: The upward trend in gold prices has clearly diverged from the downward trend in interest rates.

What will the U.S. government do? The U.S. government will do everything it can to avert deflation. Deflation is a greater threat to a debt-loaded economy than inflation because it threatens to balloon real debt-service burdens. The government will continue to pump the money into the economy through quantitative easing and fiscal spending. Should this effort raise a red flag about imminent inflation and implosion of the U.S. debt bubble? Not really. Japan’s public debt-GDP ratio is double that of the United States. For decades, Japan has been fighting deflationary—not inflationary—forces. The same trend of near-bottom interest (and inflation) rates and scarce opportunities for high yields may engulf the U.S. economy. In such an environment, primarily for speculative reasons, gold should not lose its luster.

Disclosure: "No positions"